The global banking industry may have set a new record in earnings last year, but concerns persist over weakening margins brought about by low interest rates, higher competition and the rise of fintechs, a new McKinsey study showed on Wednesday.

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Singapore

THE global banking industry may have set a new record in earnings last year, but concerns persist over weakening margins brought about by low interest rates, higher competition and the rise of fintechs, a new McKinsey study showed on Wednesday.

The sector earned a record US$1 trillion in post-tax profit in 2014, driven by robust growth from Chinese lenders, the report said. Banking profits remain the fattest among any other global industry. More than half of the profits - or US$613 billion - were registered by the top 500 banks.

"Looking back at 2012-2014, it seems that banks have settled into a new reality, characterised by steady return on equity (ROE), slow growth and strong cost control," the report noted. "This is a marked and welcome contrast from the financial crisis and also from the unsustainable expansion of the pre-crisis years."

Profits from Chinese banks have quintupled since 2007, though there are signs of a slowdown.

Notably, global revenue growth will likely continue at a pace of about 3 per cent annually over the next few years - a growth closely aligned to global gross domestic product.

But this will come as margins continue to erode, the consultancy added, with a decline of 185 basis points in margins last year.

The margin erosion can be balanced "to a degree" by improvements in operating costs, McKinsey noted, adding that capital has been largely replenished.

ROE is expected to continue tracking between 8 per cent and 10 per cent annually, it said, noting that this rate would not cover cost of equity at some banks.

"Given the cracks beneath this stable surface - cracks that may now be widening - the forecast is an uncomfortable one," said McKinsey.

It highlighted that the banking system is much more volatile than it was between 1980 and 2001, with 40 per cent of all banks seen by investors as so risky or poorly managed that they are not worth their book value.

"The system is also vulnerable to shocks; paper-thin margins would collapse if a major political crisis, a big drop in asset prices, or widespread recession were to occur."

And while many bank leaders are counting on a rise in interest rates to lift profits, this may not necessarily materialise. Margins will not return to previous levels, since much of the benefit will get competed away, and risk costs will likely increase, especially in economies where the recovery is still fragile, said McKinsey.

This also comes amid challenges from fintechs, particularly in retail banking, that also threaten margins.

The widespread adoption of technology has meant that customers can shop around for better products, and reject higher fees from their primary bank. Previously, they had found this difficult, or were too comfortable, with the status quo.

"As digitisation accelerates, banks will be in a battle for the customer that will define the industry for the next 10 years," said McKinsey.

This break in inertia can dramatically alter the landscape: banks now earn an attractive 22 per cent ROE from origination and sales, which would include fee-based businesses. A large part of the income comes from payment fees, sales charges from asset management and insurance, and fees from loan processing.

The lending alone generates just 6 per cent in ROE.

"Technology allows for new behaviours that neither banks nor customers can anticipate," said McKinsey.

"Well-designed technology permits customers to act on behavioural biases they have always had - to save time, to receive immediate gratification, to socialise with friends, to have the latest technology, to favour the elegant and beautiful over the humdrum and pedestrian."